Interview at the DNB Banking Seminar
Interview with Andrea Enria, Chair of the Supervisory Board of the ECB, conducted by Martin Arnold on 10 November 2022
15 November 2022
Let's start with the macroenvironment, this uncertainty. Russia's invasion of Ukraine has caused an energy crisis that looks likely to plunge Europe into a recession. Is it time for banks to tighten their belts and to build capital buffers in preparation for tougher times ahead? Should they be much more cautious than they have been on dividends, share buybacks and even bonuses?
First of all, let me thank Steven [Steven Maijoor, Executive Board Member of De Nederlandsche Bank (DNB)], Thijs [Thijs van Woerden, head of European Banks Supervision Division at DNB], the DNB for having me here, and all of you for participating. It's very important to me to have these events. These country visits are really very important for my job. I get a lot of feedback, which gets me thinking and helps me to respond to difficult questions on the European banking sector.
I think the starting point has to be that the European banking sector is now in a pretty strong position. The capital position is at its strongest since the start of the banking union. We have seen asset quality improving even throughout the pandemic. The stock of non-performing loans is still being reduced, throughout the year. We don't yet have the data for the third quarter but they are still going down. The liquidity position is also very, very strong and profitability has started improving.
So the interest rate increases are playing, as Steven was also saying, a very positive role in the banks' P&L (profit and loss statement). We had waited for a long time to exit the negative interest rate policy and to see this improving the banks' balance sheets. So the banks are in a strong position. But again, the point is that there is a lot of uncertainty. The macro outlook is deteriorating pretty fast. During the pandemic we started with a very negative projection, with a very deep recession and a very slow rebound being projected. Then, also thanks to the government and monetary support, each projection was better than the previous one. Now, however, we are seeing a slow deterioration in the macro outlook. We started talking about a slowdown, then stagflation and now a shallow recession – and we cannot rule out more negative outcomes.
In my view, the increase in interest rates has been much faster and stronger than was expected. I am concerned that there could be pockets in the financial sector – not within the banking sector, but outside – of highly leveraged entities that might be wrong-footed by an unexpected increase in interest rates. What happened in the UK market recently was a big warning for the whole financial sector. Whenever these episodes happen, banks are affected – indirectly or directly – via market dynamics of these entities doing fire sales of assets, or via direct exposures, repo or counterparty credit risk. So these risks need to be very closely watched. As supervisors, of course it's our task to instil a good degree of prudence in banks' behaviours, both in provisioning behaviour and the point that we are now asking banks to focus on: capital trajectories. We asked banks to send us their capital trajectories again and on this basis we will engage them in a dialogue on distribution policy.
Let me be clear here because sometimes I see in the way the press reports on this that there is always the vibe that the ECB is changing its attitude, constraining dividends. Our policy remains the same. Last year we asked the banks for the trajectories. We received capital trajectories that were very strong, very positive. On that basis the banks have been able to distribute big. We have recently had quite a number of very hefty share buybacks: Intesa €3.4 billion, Unicredit €2.6 billion, ING €1.9 billion, if I remember correctly, Caixa €1.8 billion. There have been quite a lot of significant buybacks, so we have not been constraining. What is changing now is not our policy; it's the macro outlook.
So we want the banks to recalculate their capital trajectories with a recessionary environment, with a potential gas embargo, and to show that they will be able to distribute, to respect their distribution plans to remain well ahead of their targets and our supervisory yardsticks.
Just to be absolutely clear on this, because I know this is a topic that is very close to many people's hearts in the banking sector: in the COVID crisis, during the pandemic, you recommended the banks didn't pay any dividends or distribute any capital to shareholders through share buybacks. That was lifted in September 2021. Is there any chance of it going back to that?
No, I've said this several times – and thanks for letting me repeat it here – that was an extraordinary situation. We had no visibility whatsoever. The economy froze. We were unable to differentiate between the potential impact on a bank with a high capital position and a bank with a much tighter capital position, because the hit could've been of a size that was very difficult to foresee. Now there is a lot of uncertainty, still, but of course we can do much more granular work on exposures to vulnerable sectors and banks which have specific exposures to Russia or Ukraine; banks which have large exposures to customers which are very sensitive to interest rates; banks very exposed to leverage finance or to counterparty credit risk. So we can tailor our supervisory response and dialogue with banks on a bank-by-bank basis, which, as Steven said, is what we will do in the coming weeks and months.
On provisioning, do you think the banks are being too optimistic still, in general? Particularly because presumably their models capture the recent past in terms of default rates. Default rates were incredibly low. Bankruptcies across Europe fell during the pandemic; they didn't rise because of the incredible support that was provided by fiscal and monetary policy. So does that skew the models to automatically make banks too optimistic about the future?
Well, that is a very important point that you make, and indeed that is not only on banks; our models also tend to be skewed in these cases. Maybe in the past, when I myself came out with very strong warnings of a tsunami of non-performing loans during the pandemic, our models were giving estimates which were skewed to the upside because we were factoring in the history of the great financial crisis and the sovereign debt crisis and also the lack of efficiency in secondary markets that was prevailing back then. So we came up with estimates which were probably actually, with hindsight, extremely high – way too high. Now we run the opposite risk: that we factor in the data of a very positive period and we come out with estimates which are too low.
Now, I know that banks are also between a rock and a hard place; they need to convince their auditors that their models are not so reliable and need to do a little bit of a top-up. There are different practices across Europe. Some banks are trying to allocate more provisions on individual counterparts, others do more overlays. So, what we are doing right now is to try to get an overall picture. The beauty of the Single Supervisory Mechanism – of the banking union – not only for the supervisors, but I hope also for the banks to some extent, is that we can give a lot of feedback in terms of peer benchmarking, so where you are compared with your peers across the banking union. We can identify banks that maybe are being a little bit less prudent in their provisioning behaviour and have an intensified dialogue with them. But in general, yes, this is the moment when some attention should be paid to provisioning in light of the uncertainty that is building up.
You said in a speech earlier this week in Frankfurt that there is a unique combination of risks, to quote you, facing banks and while higher interest rates are providing a short-term boost to their profits, they're not taking enough account of the downside risks. One way that they're not doing this is by, it's an accounting – not a trick – but an accounting feature that you said that they are accounting for many of their assets on an amortised cost basis so that they don't have to mark them down in value even though the asset prices have actually fallen as interest rates have risen. Have I got this right? Are you concerned about that? What is it you want to see banks do to capture that risk that is on their balance sheets?
Yes, the point was a bit technical, I realise, but the point is that if you look at the interest rate environment and the impact of rising interest rates on banks' balance sheets, if you look at the earnings position, it's very positive. That is also acknowledged in our analysis – we tried to do this two hundred-basis points shock on the banks' balance sheets. Even in a significant slowdown scenario, in a three-year perspective, this is positive for banks. So there is a tiny impact on capital and a significant increase in interest income. The point is that this again looks at the assets and liabilities according to their accounting values. But if you look at the market value, sometimes the valuation losses implicit in the increase in interest rates are not recognised.
My experience when I started at the European Banking Authority (EBA), the times Steven was remembering, it was quite a tough start for me, with the outbreak of the sovereign debt crisis. It was a big lesson for me. We published the results of the stress test; everybody was concerned about sovereign exposures and we gave full disclosure of the exposures of banks to sovereigns. What the market analysts did was to do the mark-to-market of the whole sovereign book, irrespective of which accounting book it was placed in. As a result, there was a bank like Dexia that fared very well in the stress test because, on an amortised cost basis, they were doing well. But they had massive exposures to sovereigns, municipalities in Greece, Italy, Spain and Portugal. So on a mark-to-market basis, their capital was basically depleted. And the bank lost access to funding markets in three weeks.
Don't get me wrong – the earnings base is a good perspective. It's a relevant one. I don't want to move to mark-to-market accounting for banks. That would not make sense. But at the same time, when you have extreme movements in interest rates, the ability to access funding markets, the cost of funding can react very sharply to these effects. It is important that in managing interest rate risk, banks consider these developments closely.
So should they be capturing some of this impact on asset values in their internal stress tests and their capital modelling?
Yes, absolutely – and also in their hedging strategies and so on. They should be actively managing this interest rate risk rather than remaining exposed to these types of shock that may not be affecting their earnings so much, but could affect their access to funding markets.
Now to pick up on something else that Steven said in his speech earlier: I hear that some of the banks are turning your arguments around on you and saying that yes, the macro situation has deteriorated. The outlook has deteriorated. Therefore, we shouldn't actually go ahead with finalising the Basel III reforms to capital and to the output floor because times are too tough. We should delay this, and we should extend some of these exemptions that are being introduced. Do you buy that argument?
No, I don't buy it at all!
What a surprise!
First of all, let's remind ourselves: we are talking about an agreement that was signed in 2017, will start operating in 2025 and will be fully phased in in 2030. So we are not talking about something that will impact your balance sheet tomorrow. I have been critical of that. I accept that, but I have been critical because if you look at the major difference between the effectiveness with which the US responded to the great financial crisis and how the EU responded to the great financial crisis, it is that the US did the stress test and forced the banks to recapitalise upfront, so there was the immediate recapitalisation of the banks. Then they repaid the government very fast. The incentives for repayment were very strong. In two years, three years max, the transition was completed. Banks were brought from this level of capital to that level of capital.
We adopted more the regulatory path: the reform, the implementation, the phasing in. This meant that for a number of years, banks were building up capital by being more restrictive in the way in which they were lending to the economy. This had a macroeconomic impact, in my view. Having the upfronting of these changes I think is much more effective. This also leads me to the main point, that raising capital requirements is a transitional point. When you get to the new point, if you have more capital you are more able to lend to the real economy. If there is a shock, you have a stronger capital position. We have seen it at the beginning of the pandemic. If you compare the behaviour of lending standards in 2009 and 2010 with 2020: in 2009 and 2010, the shock arrived and bank lending standards tightened massively – there was a knee-jerk reaction to the new risk environment. In 2020 lending standards didn't move. Banks kept lending to the economy and this was what helped the economy recover so fast.
Having well-capitalised banks is a real asset for the economy as a whole. Sometimes I get a bit depressed seeing how our legislators still accept this argument that if you relax capital standards here and there, you will get more lending. I think it's just a misrepresentation of reality.
Let's talk about financial stability. The ESRB warned last month of severe risks to financial stability. It is I think the first time that the ESRB has ever issued such an official warning due to a toxic combination of an economic downturn, falling asset prices, rising interest rates and financial market stress. Could the eurozone face a similar financial market crisis as the UK has gone through because of some unsupervised parts of the financial system and the sharp rise in interest rates suddenly causing it to blow up? Do you worry about this?
I do. I am not saying that I see this risk, that I have data showing me this risk. What I am concerned about is that there are areas of the financial market in which I do not have enough visibility. There was this nice speech that Sarah Breeden, from the Bank of England, delivered a few days ago, describing exactly these dynamics. The point is that if you take a snapshot of the financial situation of our economy back in 2010, and then the same snapshot right now, what you see is that the banks have reduced their leverage. The capital ratios improved so there has been a reduction in leverage. The indebtedness of governments, households and corporates increased, so there must be an increase in leverage in the non-bank financial sector that has filled the gap.
Some of this leverage, as Sarah says very eloquently in her speech, is not visible even to the banks that financed these counterparts because it is synthetic leverage built through derivative positions. As we've seen in the Archegos case, it can materialise out of the blue on banks' balance sheets, generating massive losses. The European financial market maybe has less of these types of entities, but this should not make us complacent that these things will not happen in our banks. We could be affected through a number of channels. We should be very much aware – which is why we have focused very much in our supervisory work this year on prime brokerage, on counterparty credit risk, on leveraged lending, so especially lending to leveraged buyouts or private equities which have financed leveraged buyouts. These are the areas to which I think we should pay attention. We are doing that, but we should be humble in admitting that we don't see enough, and that something can surprise us negatively.
Just on your review of banks' exposure to leveraged lending: what has been the result of that review? What have you found? Have you found concerning areas, things that worry you in that area? Are you upping banks' capital requirements as a result of the findings?
Yes, this has been an area in which we issued guidance back in 2017, and this is an area where we have been disappointed. The banks have not followed our guidance. We asked banks to put limits on their origination of these highly leveraged exposures, which we defined as exposures to counterparts which have six times debt-to-EBIDTA ratio, and the amount of these exposures actually increased. Now, I think if I remember well, the overall amount [of leveraged finance exposure] is 65% of Common Equity Tier 1 capital for the banks exposed to these sectors. So there is a significant impact on capital. The covenants were reduced through time but it has been a very competitive segment of the market.
Cov-lite. So much more cov-lite?
Yes, cov-lite, and what we saw is that the market already went into a hard stop in 2020, and at that time the central banking cavalry stepped in and started buying. This managed to avoid huge losses for the banks. Now my concern is central banking support will not be forthcoming. Central banks are exiting from the purchase programmes. The willingness and ability of central banks to provide the same kind of safety net to these markets is much reduced. We sent a letter to CEOs earlier this year. We have been following up on that, and for some banks this year we will also have some capital add-ons in the SREP process. Not huge figures but already signalling to banks that we want to see a change.
Can I ask you about digital challenges and in particular the banks' ability to assess their exposures through risk data aggregation I think is the technical term for it, but basically it's the banks' ability to look across the whole banking group and to assess their exposure to a certain counterparty or a certain sector or a certain entity. To be able to get those data at the click of their fingers so that they can very quickly assess whether they have too much exposure. Are banks able to do this, or are they still lacking in this area? I think it's an area of concern, isn't it?
This was one of the main lessons of the great financial crisis, right? I remember, all of us, in the supervisory community and in the industry scrambling to try to reconstruct their exposures to Lehman. When you have entities which have sometimes hundreds of subsidiaries across the world and you are not able to even put your data together. Also on the production side, many banks which have grown through mergers, sometimes did not manage to integrate sufficiently their own IT system and have been unable to aggregate information. There is a specific standard from the Basel Committee in this area which was outlined already by the ECB some time ago. Progress has been underwhelming here, so this is an area which we plan to include among our supervisory priorities for next year.
Another challenge linked to that to some extent, is that banks are, I would say rightly, to a large extent relying more and more on the cloud for their data. This is managed by entities, by third-party providers. This issue of outsourcing critical functions to third-party providers, has become very relevant for us. This is another topic on which we are focusing our attention more and more – which was by the way also brought to our attention by the case of Amsterdam Trade Bank, so here in this country. A small bank, a subsidiary of a Russian bank that was subject to sanctions. Therefore, the third-party provider from one day to the other stopped granting access to services. The Bank was operationally unable to perform and had to be liquidated.
Another case which was interesting from a different perspective was Deutsche Bank. Deutsche Bank had an important IT centre in Saint Petersburg. This is a case of intragroup outsourcing, so in a sense, doing work for the whole group. Then the war started. They had to ringfence their own IT centre and had to scramble to move the staff from this IT centre to Berlin to continue providing services. Luckily enough, that centre was providing services to transform the bank, so it was not a critical function for running the bank. But there were still critical services that were not available because of the location of the centre, which has made many banks reconsider also where to locate their own IT centre. These topics are becoming more and more important.
Just on that: I can see the risks there of banks outsourcing such critical functions to third-party cloud providers, and also geopolitical events could lead to accidents or failings in this area. What do you want banks to do and what do you want to be able to do as a supervisor? Do you want to be able to supervise these third-party providers? What is it you're looking to do?
That is in a sense something which is already in the pipeline. DORA – the directive on operational resilience – empowers European authorities, the EBA in particular, to have some form of scrutiny of these critical third-party providers. I think that's a movement in the right direction. But we also need to have an ability as supervisors to vet to some extent the contracts that the banks are entering into when they outsource critical functions. Banks have registers of their contracts and we are now collecting the information from these registers, identifying which types of concentration of risk we might have. If everybody of course is outsourcing certain critical functions to a single third-party provider, if this third-party provider goes underwater because of a cyberattack then the whole banking sector can be drawn down as well.
We need to see distributions and concentration of risk. In some cases you can also have some sort of backup. What is important for us is operational resilience. So if something goes wrong, you should show us which types of mechanisms you have in place to make sure that you can continue delivering your critical functions. That is our supervisory perspective and that is the way in which we will prioritise these issues.
Two more quick questions on the digital aspect of banking. One is, it won't have escaped your attention that there's been another major meltdown in the crypto-world this week with serious problems and crisis at FTX, which is one of the major crypto-exchanges and trading platforms. How worried are you about banks and their exposure to crypto-platforms, crypto-trading and crypto-assets?
The crypto-market went into a serious crash this spring, and there were no ripple effects, nothing to be noticed on the banking sector, which shows that the degree of interconnectedness between banks and these entities is extremely low and that in general, this market, although it catches a lot of attention, is still not big enough to really generate a financial stability concern right now. So at the moment I don't see a banking stability issue emerging from this development.
It’s self-contained in the crypto-world?
Yes. Of course it causes an impact on investors. I see a huge consumer protection issue. I was for instance concerned, reading a report in the United States showing that the investors who are most exposed to these kinds of providers of crypto-assets are the weakest parts of the population: the less wealthy, the poorer, the minorities. That is a concern, that is an important challenge for the consumer protection authorities. But going forward, the challenge for us is that, I sense that banks are not into the market but are very attracted by the technology, especially smart contracts. My impression is that banks will need to engage in some way or another with this crypto-world. I met a banker a few weeks ago telling me that not enabling banks to enter into this field, in his view, would be like going back to the 1980s and asking to have a contract written on paper and signed rather than having them drafted on the computer.
The key point was how to accompany this engagement. Now, the Basel Committee is developing standards for banks' exposures to crypto-assets and that will be an important step forward. The other step forward which is important of course is attracting this world under some form of regulation. I am proud to some extent that the European Union is the first jurisdiction in the world that manages to bring these entities under some form of supervision. I am concerned for my colleagues that will have to perform this supervision in the future because these are animals with whom it is difficult to engage. When you're talking about risk management with them, they have a different mindset. They think of IT security only; they never think about financial risks, so I don't know how our toolbox will work with these types of animals. But it will be an interesting challenge.
They're also hard to pin down; they're amorphous in terms of where they’re based or who’s in charge.
Yes. Our tools are focused on legal entities and on territories. Both issues with these crypto-asset providers are not there. I was talking to a major provider recently complaining about a feature of our MiCA regulation that would imply that a significant amount of the issuance should be denominated in euro. They said: this is unreasonable, it should be changed, but eventually if you don't change it, we will provide European customers with the same type of dollar-denominated assets via the internet through our shop in some other jurisdictions. It will be very difficult to police these types of requirements.
Given all these challenges the banks face in the digital world, do you think that they have enough IT and technology expertise on their boards to cope with this?
Some of the actions that you've taken as a supervisor to try and check up on this have ruffled a few feathers and there have been letters from chairmen of leading French banks, who shall remain nameless, complaining about overstretch and over-intrusion by your supervisory teams. What do you have to say about this?
Well, let me first mention the IT point. There is an interesting finding that went a bit unnoticed because the report was published probably when the COVID turmoil was starting. So not many people paid attention to that, but it is an interesting finding, I think. The banks that have IT expertise on the board have been the banks which have been least prominent in terms of cyberattacks and more resilient to cyberattacks. I think that that tells you something; that having this knowledge at the top of the shop is an important element.
On the issue that you were referring to, we think that governance is a key component. Whenever you have a bank that fails, there is always a failure of governance. There could be other aspects, such as too much risk-taking in some fancy areas of the financial market. But there is always a failure of governance, so that is the core issue. I think it is a wrong characterisation to say that our work on governance is to some extent aiming at taking the steering wheel out of the hands of the management and driving the car ourselves. That is not our purpose at all. First of all, although there were some countries in which this was a practice before the start of the banking union, we do not have people sitting on the boards, and we will never ask for that to happen.
We challenge the governance and we think that if you want to check how the board works – and we are now doing a targeted review of management board effectiveness, so on the challenge, on the dynamics within the board – I think that you cannot do that on paper looking at documents. You need to have some observation on what happens around the board meetings. So asking banks to be invited to a board meeting and have the possibility to observe what happens there, to some committee meetings, I think that is very valuable. By the way, this is also how I read the criteria which are fleshed out in the Basel standards on corporate governance that were published a few years ago, so I think we are absolutely within our remits, not excessively intrusive. Honestly, I also think that there could be value-added for the banks. I am now asking a team of experienced supervisors to review our SREP because I think that there could be value for us to be put in front of a mirror to see how external parties see us. Are we efficient? Are we effective, are we achieving our goal? I think it would be also good for the banks when we say: look, we came to your board, this is what we noticed. This is the way in which we think you have a strong board, this is where we think you are weaker than your peers. I think that could be value-added for the banks, too.
Do other regulators do this? Bank of England, the US Federal Reserve, do they do this?
Well, yes, this point was also inaccurate. It's true that some other regulators – the Fed for instance – relies more on a permanent presence of staff in the banks; they have their own staff that have offices in the banks and work there, and there is unfettered access to staff and data in the banks. In other cases, other authorities instead observe and engage in a similar way as we do.
This week of all weeks, I should ask you about climate change. We've obviously got COP meetings going ahead in Sharm el-Sheikh. The ECB in the past couple of weeks has expressed again deep dissatisfaction with the progress that banks are making in terms of assessing and addressing the climate risks that they have in their own balance sheets. So what do you think about that? What can you do to encourage the banks to take these risks more seriously? Will this require increased capital requirements again? At what point would we get to that – because we're not quite there yet, I think?
You are right. Let me also say that we are now at a moment in which we could start being a little bit less generic in our assessment. Although it is true that we are dissatisfied with the amount of progress which is being made in these two years since we issued our supervisory expectations, it's also true that there is a pretty diverse distribution across banks. So there are banks which have taken issues seriously, that are starting moving in a material way. There are banks that definitely need much more of a push in this area. So what I would characterise as a novelty in our approach this year, both with the stress test and the thematic review that we published last week, is that we'll start highlighting good practices.
Banks sometimes push back and say: you are asking us too much, we don't have data, our customers are not willing to give us the data. We don't have enough visibility on the transition paths to net zero. So until this information is available we cannot do a proper job. So come back in, say, a few years. Instead we are showing that some banks have developed good practices both in getting these data from their customers, or in developing proxies that enable to effectively manage these risks. Or on developing their own trajectories to net zero and checking their customers against this yardstick. So there are good practices out there, and I think this is a good starting point to engage in a dialogue with the industry. We gave the end of 2024 as a deadline to be in line with our expectations. So this dialogue should lead us there. As I say, some banks are more advanced, some are less. Now of course if the less advanced banks do not move and remain at the back of distribution, there will be a moment in which we will need to move to some supervisory action. Be it capital, be it some enforcement action – but there will need to be some action there. Again I don't think we are still talking about the Pillar 1 requirements at the moment. This is still being debated in Basel, but it's important that banks understand this is not a talking shop. There will be a moment in which lack of alignment with our expectations will lead to consequences.